Despite the challenges posed by COVID-19, 2020 saw an eruption of IPOs by
special purpose acquisition companies (SPACs), used to raise nearly $79
billion from investors.
The Wall Street Journal reports that the trend is continuing in 2021, already averaging five new SPACs each
business day. A surge in related litigation has already begun, and it can
be expected to grow and become a feature of SPAC deals throughout 2021.
SPACs are publicly traded companies created as vehicles to take promising
private companies public. A SPAC offers securities for cash, and places the
offering proceeds into a trust or escrow account to be used to acquire one
or more operating companies. After the IPO, the SPAC generally has a
limited amount of time to identify acquisition targets. SPACs sometimes are
called “blank check companies” because their investors give management
discretion to identify and acquire private companies after the IPO.
Investors in SPACs may redeem their shares for the purchase price once the
target company is identified. Without such an election, the investors
become owners of the newly merged company. Typically, the management team
puts up 20 percent of the equity at the outset, and the remaining 80
percent is sold to the public via the IPO. They may have other financial
incentives that differ from those for public shareholders, such as
compensation arrangements or relationships with affiliated entities.
On Dec. 22, 2020, the U.S. Securities and Exchange Commission (SEC)
Division of Corporation Finance (Corp Fin) issued
guidance highlighting the potential for conflicts of interest between a SPAC’s
management team, directors and officers on the one hand, and the public
shareholders on the other. Corp Fin warned SPACs to consider carefully
their disclosure obligations in this regard. The guidance also emphasized
the importance of fulsome disclosures about the business combination
between the SPACs and their target companies. Just two weeks before that,
the SEC’s Office of Investor Education and Advocacy issued an
investor alert about SPACs.
Right now, there is a growing trend of SPAC shareholder lawsuits filed soon
after announcements of mergers between SPACs and their target companies.
Those business combinations are often called “de-SPAC transactions.” The
lawsuits typically seek both money damages and injunctive relief to prevent
the culmination of the transaction. In addition to individual shareholder
suits, class actions are being filed.
The allegations generally center around the same issues identified in Corp
Fin’s guidance. Plaintiffs usually allege a failure to adequately disclose
to shareholders the potential conflicts of interest between management and
public shareholders, as well as a failure to adequately disclose material
information about the de-SPAC transaction — thus depriving public
shareholders of the opportunity make an informed decision about whether to
redeem their shares. After the merger is consummated, plaintiffs may amend
their complaints to allege that they would have redeemed their shares for
the purchase price if they had known the allegedly withheld information.
Some suits also allege violations of the Securities and Exchange Act of
1934. Such allegations claim the SPAC or its officers made false or
misleading statements in the prospectus the SPAC must file with the SEC
prior to the de-SPAC transaction. One of the beneficial features of using a
SPAC to acquire and take a private company public is that the SPAC can take
advantage of the “safe harbor” provisions of the Private Securities
Litigation Reform Act for forward-looking statements. See 15 U.S.C. §
78u-5. The safe harbor excludes IPOs, but a prospectus issued in connection
with a de-SPAC transaction is covered if the statements are identified as
forward-looking and if suitable, “meaningful cautionary statements”
accompany the information.
Plaintiffs can and do still allege, however, that a prospectus lacked the
disclaimers and “meaningful cautionary statements” required to fall within
the safe harbor provision or that the allegedly false statements involved
then-existing facts, thus removing them from the safe harbor. Plaintiffs
also allege a moral hazard of the typical SPAC arrangement: The management
team has a limited time from the IPO to complete the business combination,
or the SPAC terminates. The management group stands to make a substantial
profit if a deal is completed but will lose out if the SPAC terminates
without a merger. This can be said to create an incentive to just get some deal done — irrespective of whether it is good for the
While it may be an uphill battle to persuade a court to enter a temporary
or preliminary injunction to stop a de-SPAC transaction, the mere threat of
it can add uncertainty and affect the market price of the SPAC’s publicly
traded shares. If the court denies injunctive relief and the deal closes,
the new business combination will incur the costs and distraction of
defending such lawsuits.
As a matter of defense strategy, parties to a SPAC transaction should
always point out the obvious: If a shareholder does not like the proposed
de-SPAC transaction, there is an immediate and obvious remedy — simply
redeem the shares and walk away. This makes any claim for damages
difficult, and the avenues available to the shareholder are limited to
asking for either (1) the lost opportunity to earn growth on the value of
the shares in some other investment during the period the SPAC shares were
owned, or (2) the lost value the shareholder would have realized had the
de-SPAC transaction been handled differently. The former is of limited
value in most cases, and the latter is rather speculative.
As SPAC IPOs and the ensuing de-SPAC transactions increase in frequency,
expect a corresponding increase in related securities litigation. Parties
are advised to retain litigation counsel experienced in defending against
shareholder suits and class actions.